When you sell a home with increased value, you might have to pay a capital gains tax. This tax is on the profit you make from selling your home. However, because of the Taxpayer Relief Act of 1997, most homeowners don’t have to pay this tax.
Key Points:
Tax Exemption for Primary Residence:
If you are single, you can sell your main home and not pay capital gains tax on the first $250,000 of profit.
If you are married and file taxes jointly, you can exclude up to $500,000 of profit from taxes.
You can only use this exemption once every two years.
Adding to Your Exemption:
You can add the cost of your home and any improvements you made to it to your $250,000 or $500,000 exemption.
Tax Rates:
Short-term capital gains (if you owned the home for less than a year) are taxed like regular income, which can be as high as 37% for people who make a lot of money.
Long-term capital gains tax rates are lower: 0%, 15%, or 20%, depending on your income and filing status.
To avoid a capital gains tax shock after selling your primary residence, you can follow these strategies:
Understand the Exemption Limits:
If you are single, you can exclude up to $250,000 of profit from capital gains taxes.
If you are married and filing jointly, you can exclude up to $500,000 of profit.
This exclusion is only available if the home was your primary residence for at least two of the five years before the sale.
Meet the Ownership and Use Tests:
To qualify for the capital gains exclusion, you must meet both the ownership test and the use test:
Ownership Test: You must have owned the home for at least two years.
Use Test: The 2-in-5-Year Rule You must have lived in the home as your primary residence for at least two (730 days) of the last five years before the sale. These two years do not have to be consecutive.
Time Your Sale Carefully:
If you have recently sold another home and claimed the exclusion, be aware that you cannot claim the exclusion on another sale within two years
.
Convert a Rental Property to a Primary Residence:
If you have a rental property, consider converting it to your primary residence for at least two years. This can help you qualify for the exclusion, though other rules apply to properties that were previously rentals.
Keep Detailed Records of Home Improvements:
Increase your home’s basis by adding the cost of substantial improvements (e.g., remodeling, adding rooms, landscaping) to reduce the capital gain. Repairs and maintenance, however, do not count.
Keep detailed receipts and documentation of these improvements to substantiate your claims.
Consider a 1031 Exchange:
Although primarily used for investment properties, a 1031 exchange allows you to defer capital gains taxes by reinvesting the proceeds into a similar property. This doesn’t apply to primary residences, but if you convert your primary residence to a rental first, this could be an option.
Plan for Your Future Housing Needs:
If you plan to downsize or move to a different home, consider the potential tax implications and plan accordingly.
Tax Rates:
Short-term capital gains (if you owned the home for less than a year) are taxed like regular income, which can be as high as 37% for people who make a lot of money.
Long-term capital gains tax rates are lower: 0%, 15%, or 20%, depending on your income and filing status.
Widowed Taxpayers and Capital Gains Tax
If you are a widowed taxpayer, you might be able to increase your tax-free profit from $250,000 to $500,000 when selling your home if you meet all of these conditions:
You sell the home within two years of your spouse's death.
You haven't remarried by the time you sell the home.
Neither you nor your late spouse used the tax exclusion on another home sold less than two years before this sale.
You meet the rule of living in and owning the home for at least two years.
By understanding these rules and planning, you can minimize or even avoid a capital gains tax shock when selling your primary residence.
How to Reduce Your Home Sale Profits
If your profit from selling your home is more than the IRS exclusions ($250,000 for singles and $500,000 for married couples), you can lower your taxable gains by increasing your home’s “basis” or original purchase price. This can be done by adding certain home improvements that you made, which extended the home's useful life, according to the IRS.
Here’s how you can increase your home’s basis:
Add the Cost of Improvements: You can include the cost of major improvements, like home additions, updated systems (like heating or air conditioning), landscaping, or new appliances. These improvements need to add value to your home or extend its life.
Exclude Repairs and Maintenance: Regular repairs and maintenance, like fixing a leaky faucet or painting, do not count toward increasing your home’s basis.
Keep Detailed Records: It’s important to keep detailed records of all capital improvements because you will need proof if the IRS audits you. Estimates aren’t enough.
When you sell your home, the IRS gets a copy of Form 1099-S, which shows the date you sold the home and how much you made. However, you need your records to show any changes to your home’s basis to reduce your taxable profit.
Tip: Not keeping records of your home improvements is a common mistake, so make sure to save all receipts and documents related to major upgrades.
What are improvements )Publication 523 (2023) Improvements
Improvements add to the value of your home, prolong its useful life, or adapt it to new uses. You add the cost of additions and improvements to the basis of your property.
The following chart lists some examples of improvements.
Examples of Home Improvements That Increase Your Home's Value
Improvements are changes that add value to your home, extend its lifespan, or adapt it to new uses. When you make these improvements, you can add their costs to the basis of your property, which may help reduce your taxable profit when selling.
Here are some common improvements that increase your home’s basis:
Additions:
Adding a new bedroom or bathroom
Building a deck, garage, porch, or patio
Lawn & Grounds:
Landscaping, installing a driveway or walkway
Adding a fence, retaining wall, or swimming pool
Systems:
Installing or updating a heating system or central air conditioning
Adding a furnace, duct work, central humidifier, or central vacuum
Setting up air or water filtration systems, new wiring, security systems, or a lawn sprinkler system
Exterior:
Adding storm windows or doors
Installing a new roof or siding
Setting up a satellite dish
Insulation:
Installing insulation in the attic, walls, floors, pipes, or ductwork
Plumbing:
Upgrading the septic system, or water heater, or adding a soft water or filtration system
Interior:
Installing built-in appliances
Modernizing the kitchen or adding new flooring
Adding wall-to-wall carpeting or a fireplace
These improvements can increase the value of your home and may help you save on taxes when you sell by increasing the home’s basis.
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